UK Budget: Rachel Reeves' Balancing Act Between Markets and Party

Key Takeaways:

• Rachel Reeves' dual challenge: appeasing bond market investors and Labour Party members.
• Focus on economic growth as a solution, but achieving it remains difficult.
• Controversial new tax proposals could impact market confidence.
• Importance of a fiscal buffer to soothe anxieties and reduce the need for future tax hikes.
• Need to address the cost of living crisis to win voter support.

Eighty-three days after UK Shadow Chancellor Rachel Reeves announced the second budget date, she is trying to convince both bond market investors and Labour Party members that this budget takes their interests into account. The question is: will she succeed?

When Reeves stands before Parliament, the picture will become clear about her ability to balance these two conflicting goals. Initially, she seemed to prioritize the market, but over time, she began to lean to the left to please Labour MPs. This shift has become necessary for her political survival, especially with the challenges facing Keir Starmer's leadership.

Reeves needs to present measures that reassure MPs who are pressuring Starmer, while also meeting the demands of government bondholders, who demand a risk premium on UK bonds compared to bonds from countries like the United States, Germany, and Japan.

According to leaked statements, Reeves will emphasize that she will not return the UK to an era of austerity, nor will she lose control of public spending through reckless borrowing. At the same time, she will seek to implement the largest growth plan in a generation.

The solution lies in economic growth, but it has not yet materialized. Although the government has achieved the goal of "fastest growth in the G7," this growth has not been sustainable. Chronic productivity problems that hinder the British economy will appear in the calculations of the Office for Budget Responsibility (OBR), which will limit her room for maneuver.

Luke Tryl, Executive Director of More in Common, says that Reeves faces a difficult task. He adds that her core claim that the budget is responsible and contains a sufficient margin of safety, while also reflecting Labour Party values and achieving redistribution, may be the only solution that satisfies all parties.

Reeves has previously faced difficulties due to sudden changes in policies, obstacles caused by Trump's global trade war, and OBR productivity cuts, which led to a fiscal gap of £20 billion. This prompted her to develop a series of tax increase plans, which is unacceptable to the public, especially after raising taxes by £40 billion in her first budget.

Potential measures include:

• Freezing the income tax threshold for another two years from 2028.
• Imposing a "mansion tax" on properties worth more than £2 million.
• Restricting salary sacrifice programs.
• Increasing taxes on alcohol, gambling, and dividends.
• Imposing a new tax on electric vehicles based on miles traveled.
• Imposing a new tourist tax led by mayors.
• Reducing the annual tax exemption for Individual Savings Accounts (ISA) from £20,000 to £12,000.
• Providing a three-year stamp duty exemption period for investors who buy new shares in listed companies.

The process of preparing this budget was unusually turbulent. Reeves waved the possibility of raising income tax, a controversial measure that contradicts Labour Party election promises. But informed sources say that Reeves received improved economic forecasts from the OBR, and the plan was abandoned that week. However, it is widely believed that political risks were a major reason behind this retreat.

Frequent changes in her policies have led to significant market fluctuations, exacerbating the chaos leading up to the budget.

For bond dealers, the primary focus will be on the size of the safety margin that Reeves' tax and spending plans will create for her financial rules. She left a meager margin of £9.9 billion in the previous budget, and this figure has eroded since then. Reeves expects to build a fiscal margin of between £15 and £20 billion to reduce the likelihood of further tax increases in the coming years. Investors will closely monitor the credibility of her plans to achieve this goal.

Rachel Reeves' Fiscal Safety Margin

Rupert Harrison, Senior Advisor at PIMCO and former economic advisor to Conservative Chancellor George Osborne, says that one of the risks lies in this "mix" of tax increases, which may include a large number of taxes on capital, liquid wealth, and investment, and may not ultimately lead to the collection of expected revenues. He adds that the credibility of these tax measures is crucial.

Reeves hopes that the market will reward her budget plan, reducing government funding costs. But dealers are also preparing for a possible market shock, as investors increase currency hedging tools to guard against volatility.

Reeves will also make addressing the cost of living crisis a central focus of the budget, through policies such as raising the national minimum wage and living wage, freezing train ticket prices, and reducing energy bills.

Tryl says that given the unusual uncertainty leading up to the budget, Reeves needs to emphasize the affordability of these measures to win voter support.

He adds that many voters are more concerned about upcoming policies than usual.